Showing posts with label Games Investors Play. Show all posts
Showing posts with label Games Investors Play. Show all posts

Wednesday 12 January 2011

This Is More Important Than Investment Profits


This Is More Important Than Investment Profits

"It's all about making money that's the facts and talk is worthless."
That's the comment one reader left on an article I recently wrote about casino giant Las Vegas Sands (NYSE: LVS). Based on the available information, I argued that there wasn't a compelling case for buying Sands at today's price (just more than $50 as of this writing). The commenter in question disagreed with me, saying that we'd know who was right based on where the stock price finishes the year. After all, the comment implies, if you can't judge investing prowess based on profits, then how can you judge it?
The argument is compelling on the face. Certainly, every investor aims to make money with her or his investments. However, when it comes any particular investment, is the profit or loss that's banked really the best way to judge success or failure?
A lap around the track


Let's take the discussion to the horse track for a moment. One bettor at the track lays his money on SmartyBet, whose odds are listed on the tote board as 30-to-1, but who we know (with our hypothetical preternatural insight) has a 20-to-1 chance of actually winning. Meanwhile, another bettor puts money down on WayOverbet, a horse paying 3-to-1 whose actual odds of winning are 5-to-1.
The race is run, and WayOverbet ends up winning by a nose, paying our second bettor $3. Was that a good bet?
If all we care about is profit, then we'd say yes -- after all, that bettor has $3 instead of $1 in his pocket, while the other has a lonely spot in his wallet where a dollar used to be. But if both of these bettors make these same bets over the course of 100 races, it becomes quite clear who the smarter player is. Our first bettor will end up winning five of those 100 races, each paying $30, for a total of $150. The second better will win much more often, showing a "profit" 20 times out of the 100 races, but each will only pay $3, leaving him with just $60 for his $100 worth of bets.
Obviously, the most important thing here wasn't to show a "profit" on a given bet, but rather to make sure that each bet was smart -- that is, one that had better actual odds than what the tote board showed.
Process versus outcome


Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:
Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.
Mauboussin emphasizes the point, writing:
... investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field -- such as investing, sports-team management, and parimutuel betting -- all emphasize process over outcome.
Winning the process game


Mauboussin very clearly lays out what the ideal goal of any investment process should be:
The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.
What does this mean in practical terms? I often begin my investment research using a screen that identifies stocks with certain attributes. For our purposes here, let's say I'm looking for stocks that are currently out of favor with investors, so I set a screen looking for any stock that has declined by 20% or more over the past year and is currently trading at less than its tangible book value. Here are a few of the companies that pop up:
Company
Year-Over-Year Price Change
Price-to-Tangible Book Value
Banner Corp (Nasdaq: BANR)(23.7%)0.6
K-SEA Transportation Partners(NYSE: KSP)(61.4%)0.4
Oilsands Quest (NYSE: BQI)(59.0%)0.4
Hercules Offshore (Nasdaq:HERO)(38.1%)0.4
American National Insurance(Nasdaq: ANAT)(26.5%)0.6
Source: Capital IQ, a Standard & Poor's company.
To follow good process in evaluating these stocks, I'd first try to identify possible outcomes for them, and what those outcomes would mean for the stock price. Washington-state-based Banner, for instance, traded at more than twice its tangible book value prior to the financial crisis, so we could probably envision a case where shares recover to three or four times their current value. American National Insurance, meanwhile, has had cyclical valuation swings that have typically put its tangible book value multiple in a range of 0.5 to just above 1.0. In a scenario where toxic assets don't eat away at the balance sheet and investment returns start to increase, investors could see real upside here, too.
Of course, we also need to consider negative outcomes, as well. For example, investors would want to note that Oilsands Quest has never reported an annual profit. There may be a huge upside if the company finds a way to profitability, but its assets may not be worth all that much if it can only produce losses. Similarly, driller Hercules Offshore has been trying to find its footing again, but the need for a balance-sheet-strengthening capital raise may impact the value of currently outstanding shares.
Once you have a list of the potential outcomes for the stock in question, you can then weigh the potential for each of those outcomes to come to fruition, and end up with a good sense of whether the stock is a worthwhile investment.
The year-end review


Any one of these stocks -- Las Vegas Sands included -- may end the year with a higher or lower price than what the ticker tape shows right now. But the best investors won't spend all of their time focusing on whether there was a profit or loss -- but rather on evaluating whether the decision-making that led to the investment was sound.
The comment that I highlighted at the beginning concluded that "talk is worthless." Perhaps talk that focuses simply on the outcomes of investments is worthless. But I think few things are more valuable than talk that discusses potential investment outcomes and helps hone process.

Wednesday 14 April 2010

Reposting on Investment, speculation and gambling (Security Analysis, Ben Graham.)

It is commonly thought that investment, is good for everybody and at all times. Speculation, on the other hand, may be good or bad, depending on the conditions and the person who speculates. It should be essential, therefore, for anyone engaging in financial operations to know whether he is investing or speculating and, if the latter, to make sure that his speculation is a justifiable one.


Investment, speculation and gambling(Security Analysis, Ben Graham.):

1. Graham defined investment thus: 
An INVESTMENT OPERATION is one which, upon THOROUGH ANALYSIS, promises SAFETY OF PRINCIPAL and a SATISFACTORY RETURN. Operations NOT meeting these requirements are speculative.
The difference between investment and speculation, when the two are thus opposed, is understood in a general way by nearly everyone; but it can be difficult to formulate it precisely. In fact something can be said for the cynic's definition that an investment is a successful speculation and a speculation is an unsuccessful investment. The failure properly to distinguish between investment and speculation was in large measure responsible for the market excesses and calamities that ensuedas well as, for much continuing confusion in the ideas and policies of would-be investors.


2. Graham's addition criterion of investment: An investment operation is one that can be justified on BOTH QUALITATIVE and QUANTITATIVE grounds.
Investment must always consider the PRICE as well as the QUALITY of the security.



Main points:______________

INVESTMENT OPERATION: rather than an issue or a purchase.

PRICE: is frequently an essential element, so that a stock (and even a bond) may have investment merit at one price level but not at another.

DIVERSIFICATION: An investment might be justified in a group of issues, which would not be sufficiently safe if made in any one of them singly.

ARBITRAGE AND HEDGING: it is also proper to consider as investment operations certain types of arbitrage and hedging commitments whichinvolve the sale of one security against the purchase of another. In these rather specialised operations the element of SAFETY is provided by the combination of purchase and sale.



THOROUGH ANALYSIS: the study of the facts in the light ofestablished standards of safety and value, including all quality of thoroughness.


SAFETY: The SAFETY sought in investment is not absolute or complete; the word means, rather, protection against loss under all normal or reasonably likely conditions or variations. A safe stock is one which holds every prospect of being worth the price paid except under quite unlikely contingencies. Where study and experiences indicate that an appreciable chance of loss must be recognized and allowed for, we have a speculative situation.


SATISFACTORY RETURN: is a wider expression than "adequate income", since it allows for capital appreciation or profit as well as current interest or dividend yield. "Satisfactory" is a subjective term; it covers any rate or amount of return, however low, which the investor is willing to accept, provided he acts with reasonable intelligence.

_______________


For investment, the future is essentially something to be guarded against rather than to be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly – and often soundly – derive its basis and its justification from prospective developments that differ from past performances.


GAMBLING: represents the creation of risks not previously existing – e.g. race-track betting.

SPECULATION: applies to the taking of risks that are implicit in a situation and so must be taken.

INTELLIGENT SPECULATION: the taking of a risk that appears justified after careful weighing of the pros and cons.


UNINTELLIGENT SPECULATION: risk taking without adequate study of the situation.

Monday 4 January 2010

Never forget that buying a stock is a major purchase and should be treated like one

You wouldn't buy and sell your car, your refrigerator, or your DVD player 50 times a year. 

Investing should be a long-term commitment because short-term trading means that you're playing a loser's game.

The costs really begin to add up - both the taxes, the brokerage costs, and the spread - and create an almost insurmontable hurdle to good performance. 

The amount you rack up in commissions and other expenses is money that can't compound for you next year.